Moore: Halfway through 2014, market moving in right direction

MONTREAL — The halfway mark of the year is an opportune time to ponder the state of financial markets and how they might fare in the next six months. In 2014, markets have reaffirmed their tendency to surprise. Many expected equities to struggle after a stellar 2013. They haven’t. Bond yields were supposed to rise. They have declined. Emerging markets were supposed to be untouchable. They have done well. Commodity prices were expected to decline on concerns about China. They have mostly risen. The U.S. dollar was supposed to assert its primacy. The evidence is mixed on that one.

Start with equities. The S&P 500 is up more than seven per cent on the year, while the S&P/TSX has seen double-digit growth. Although some have expressed concerns about overvaluation of American equities, this year’s performance has been largely driven by rising profitability. In fact, the S&P 500’s trailing price-to-earnings ratio is lower today than it was at the beginning of the year. S&P 500 profits grew at an annualized 3.4 per cent in the first quarter (Q1), but that is expected to double to 6.7 per cent in Q2, according to S&P Capital IQ.

Others have grumbled about unsustainably low volatility. A recent study by Goldman Sachs, though, shows that the S&P 500’s volatility is only slightly below average and in line with levels in the mid-1990s. In the final analysis, a stock’s future direction depends on a company’s ability to grow its earnings. Should earnings expectations materialize, equity markets will have sufficient justification for continued strength. In that regard, U.S. economic data have recently provided some good news.

Despite a surprisingly large contraction in Q1, the U.S. economy appears poised for sustained growth. Job creation has been impressive. The unemployment rate is at its lowest since 2008 and the economy is on track to create more jobs than in any year since 1999. Car sales, new home sales and capacity utilization all beat expectations in June. The widely followed University of Michigan Consumer Confidence Index is at 85, a level that has historically signalled an inflection point toward accelerating economic growth.

The U.S. Federal Reserve appears to concur. The minutes of its latest meeting confirm that the central bank is on track to end its monetary easing program by October, and that it could start raising its target rate, currently at 0.25 per cent, sometime in mid-2015.

According to the St. Louis Fed, the probability of a recession remains below one per cent, yet the bank is likely to tread carefully in raising rates lest it stifle the recovery. That could steepen the yield curve, whereby short-term rates rise slower than long-term bond yields. We refer readers to our June article in The Gazette, where we discussed what we believe to be the impending end of the bond bull market.

Even as the Fed gets set to tighten policy, the European Central Bank is heading in the opposite direction to stave off deflation in the eurozone, and the Bank of Japan continues to crank the yen printing presses to slay deflation once and for all. Broadly speaking, loose monetary policy tends to weaken currencies while higher rates tend to strengthen them, as long as inflation remains contained. The latter would result in higher real — i.e. inflation adjusted — returns, which should attract capital long starved of yield to the U.S. economy, as indeed it did last year. Accordingly, the global divergence in monetary policy bodes well for the greenback.

What might derail financial markets, you ask? Geopolitical risks, for one. Insurgents have taken over large swaths of Iraq and Syria and have declared an Islamic state. Oil prices rose mildly in response, but markets have mostly shrugged. Escalation of the sort that threatens markets remains unlikely at this point. Events in Ukraine seem to have stabilized at low-level conflict status, again with little risk to the global economy, for now. Speculation over premature Fed tightening in response to increasing risk-taking by investors could also spook markets, although Fed Chair Janet Yellen has explicitly ruled this out.

What does all this mean for Gazette readers? It is important to recognize that the global economy suffered a massive blow in 2008-2010. Recovery from such a deep recession takes time, as imbalances are corrected and balance sheets repaired. The good news is that the United States, the engine of the global economy, is revving up again. It may not be firing on all cylinders yet, but it’s moving in the right direction. We urge patience during the summer months, when markets tend to be jumpy and volumes low. Notwithstanding occasional choppiness, we see a favourable environment for North American equities for the rest of the year. Cyclical sectors that can benefit from increased consumer spending and business investment should do especially well. Short duration positions in fixed income remain prudent at this stage. The U.S. dollar and U.K. pound are better bets than the euro and the yen. Finally, we see interesting developments in the energy space, but we leave that for another article.

Robert T. Moore is portfolio manager and director of wealth management at ScotiaMcLeod.

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